The past few months haven’t exactly been kind to banking stocks. Though an improved asset market and sound balance sheet helped the sector regain the ground it lost five years back in recession, it has again found itself under pressure this year.

Lackluster activities both at household and corporate levels, high frequency trading concerns, increased regulatory scrutiny and sluggish mortgage as well as capital market business held the sector back.
Banking stocks were expected to benefit from a rising rate scenario this year after the Fed initiated QE taper in a steady and phased manner. A widely accepted view is that rising rates are followed by lenders’ rate hikes on loans faster than what is paid on deposits.

But, against popular belief, interest rates have fallen this year thanks to the risk-off trade sentiment prevailing in the market. Geo-political tension in Russia, measly growth in the U.S. economy in Q1 and a choppy housing market once again spurred the appeal for defensive plays. Consequently, investors dumped financial stocks along with some other growth stocks as of late.

Reasons Behind the Slump

Marine Cole from the Fiscal Times said “as mortgage loan application and origination volumes continue to fall, large banks are paying the price of the slowdown”. A KBW analyst also pointed out that mortgage volume has been low on a sequential basis due to lower refinance volumes.

According to the author, lowest temperatures in a decade intensified the regular seasonal slowdown and resulted in purchase volumes that lagged expectations in the first quarter. Following this, banks in the U.S. eased loan policies to businesses including real estate companies during the first quarter. For household as well, banks formulated easier credit standards.

However, with the passage of severe winter which restrained consumer confidence, the sector should see some tailwinds. Consumers’ transaction with banks might pick up in Q2. In fact, earnings growth for the financial sector should resume from Q3.

For 2014, the sector is expected to expand 3.8% on bottom line which is definitely not an outstanding growth rate, but the year next should see a 12.4% upswing on the bottom line, as per the Zacks Industry Trend (read: 3 Financial ETFs to Play the Bank Stress Tests).

While sluggish mortgage activities brought about modest losses for a number of companies in the space, pushing industry share prices down several percentage points in recent sessions, risk tolerant investors can smartly use this slump as an entry point to the sector and relish the long-term potential.

If you go by Fed Chair Janet Yellen’s recent comment that “mortgage rates went up quite a lot over the spring and summer, but they are still quite low by historical standards, so in that sense housing remains affordable, and I expect housing to pick up”, you may also see rays of hope.

While investing in a single stock will be risky in this uncertain environment, a basket approach should serve investors better. Below, we have highlighted some top-ranked financial ETFs which could be in focus in the coming days:

Financial Select Sector SPDR (NYSEARCA:XLF)

The fund tracks the S&P Financial Select Sector Index, giving investors exposure to the U.S. financial space. The fund holds a basket of 85 stocks with the top three holdings – Wells Fargo & Company, Berkshire Hathaway Inc. Class B and JPMorgan Chase & Co. – each receiving about 8% of the portfolio.

The fund also includes some well-known banks such as Bank of America Corporation, Citigroup Inc. and Goldman Sachs Group Inc. in its top 10 holdings. Sector-wise, banks occupy around 37% of fund assets, followed by insurance (about 18%) and REITs (14.2%).

The fund returned 19.5% in the past one year and has added 1.1% so far this year. Also with an expense ratio of 16 basis points, XLF is one of the cheapest in the space. The ETF currently carries a Zacks ETF Rank #1 or ‘Strong Buy’; however, it does have a high risk outlook.

First Trust Financials AlphaDEX Fund (NYSEARCA:FXO)

FXO tracks the Strata Quant Financial AlphaDEX Index, which is a modified equal-dollar weighted index. The benchmark is designed to objectively identify and select stocks from the Russell 1000 Index in the financial services sector that may generate positive alpha relative to traditional passive-style indices through the use of the AlphaDEX selection methodology.

The fund invests about $953.2 million in assets in 171 holdings. The fund is well spread across individual holdings as it does not put more than 10% in its top 10. FXO does well in eliminating concentration risk as it does not allot too much in any single constituent. Expense ratio is bit higher at 70 bps a year.

FXO gained 16.3% in the last one year but has lost 1.5% this year. FXO currently has a Zacks ETF Rank of 1 with a medium outlook (read: Top Ranked Financial ETF in Focus: FXO).RevenueShares Financial Sector Fund (NYSEARCA:RWW)

For a slightly different approach to the financial sector, investors may want to consider this revenue-weighted ETF. The product tracks the RevenueShares Financial Sector Index, a benchmark that gives exposure to about 86 stocks that are weighted by revenues instead of market cap. RWW has amassed about $31.5 million in assets. However, the fund charges 49 bps in fees.

RWW was up 17.1% in the last one year but has lost 2.2% so far this year. RWW has a Zacks ETF Rank of 1 with a high risk outlook.